Understanding and identifying trends

In this lesson, we look at what causes market trends to form and how to identify trends for the purpose of trend trading.

Why do trends form?

• Trends form in financial markets for a variety of reasons that can contribute to a sustained directional movement in the price of the asset. For example:

• There might be an imbalance in supply and demand. For example, if buyers are more aggressive than sellers, prices tend to rise, forming an uptrend. Conversely, if sellers dominate, prices decline, leading to a downtrend

• Fundamental economic factors can also play a role, such as economic events, corporate earnings, interest rates, and geopolitical events that influence market sentiment and drive trends. Positive economic data can encourage buying, while negative data can lead to selling

• Often, a trend arises from market sentiment. For example, positive news and optimism can lead to uptrends, while negative news and pessimism can result in downtrends

• Related to this is what’s known as herding behaviour, where a market starts to move in one direction and more and more traders begin to notice the trend and follow it (or the crowd already following it). In the beginning of a trend, the theme isn’t visible to many, but as it matures it becomes apparent to an increasingly less sophisticated crowd of traders until the trend eventually reaches a point of exhaustion and changes course

• Institutional activity – such as trading decisions made by large hedge funds – can drive trends as other market participants react

Trends are not always linear or persistent. Markets can experience periods of consolidation, reversals, or erratic movements, even within an overall trending environment. The price may go against the trend every now and then (a pullback is the term used to describe a pause or moderate drop in pricing chart from recent peaks that occur within a continuing uptrend). But if you look at the longer time frames, the trend continues in a specific direction. So, what makes for a trending market is that the theme strengthens and becomes sustainable.

In other words, a good trend won’t be derailed by individual fundamental events and data releases, as these act only as short-lived setbacks with market participants’ attention quickly turning back towards the broader underlying theme.

How do trend-trading strategies compare with other trading strategies?

To assess the performance of your trading strategy, you’ll likely look at certain key metrics, which might include risk-reward ratios, win-loss percentages, and total return, among others.

The risk-reward ratio involves comparing the amount you're risking to the potential gain. For example, if you're risking $100 on a trade and the potential gain is $400, the risk-reward ratio is 1:4.

The profit-loss ratio is the average profit on your winning trades divided by the average loss on your losing trades over a specific period. Read more about metrics here.

Trend-following strategies often aim for higher risk-reward ratios than strategies that involve shorter timeframes, such as day trading and scalping. This means that traders are willing to risk a certain amount of capital to potentially earn a larger reward. For example, you might set a stop-loss order that limits your potential loss while targeting a profit that is several times larger than your risk. Day trading or scalping strategies focus on capturing small price movements, and so if you choose these strategies over trend trading, you might risk a relatively small amount to target a modest profit.

It's worth noting that the performance of your trend-following strategy will be affected by how long you hold onto a winning or losing trade. The temptation to let losing trades run in the hope that the market turns can quickly wipe out any profits you may have made. This is something you can track in the IG Trade Analytics Tool, which allows you to analyse your trade history and provides mistake diagnosis and tips for improving future trading performance.

How do I identify a trend?

Aside from making a general observation by looking at a chart and seeing the direction in which a price is moving, there are other quantifiable ways to determine and measure trends. These include observing basic price action, moving averages, the relative strength index and the average directional index. In this lesson, we’ll look at observing price action and moving averages.

Observing price action

Identifying a trend through price action involves analysing the movement of an asset's prices on a chart without relying on technical indicators. One of the ways of doing this is by using trendlines.

A trendline is an illustrated line that provides a visual representation of the trend's direction and strength. You can think of them as lines that connect two or more high/low points that extend into the future. Find out more about trendlines and how to use them here.

Remember that trends can change over different timeframes, so you might want to analyse multiple timeframes to get a more granular view of how short-term movements affect the overall trend. Combining price action analysis with other technical and fundamental tools can provide a more comprehensive understanding of the market's dynamics.

Moving averages

The moving average (MA) is a technical indicator used by traders to spot emerging and common trends in markets. In a nutshell, a moving average helps you to find the average of various data points. It's especially useful for spotting trends and making sense of price movements by removing the random ups and downs, so we can see the bigger picture more clearly, revealing the main path the data is taking. It’s calculated by adding up the prices for a certain number of periods (such as days or hours) and then dividing by the number of periods. In stock market analysis, a 50 or 200-day moving average is often used to see trends and indicate where stocks are headed.

There are different types of moving averages, but two common ones are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA):

• SMA: This moving average calculates the average price over a specified number of periods equally. For example, a 20-day SMA would add up the closing prices of the last 20 days and then divide by 20.

• EMA: The EMA gives more weight to recent prices, making it more responsive to recent price changes. As a result, EMAs tend to react faster to market price movements compared to SMAs. It can sometimes be referred to as the exponentially 'weighted' moving average.

To use a moving average to identify a trend, you need to observe the interaction between the price and the moving average line on a price chart. If price is above a moving average, traders will generally take a long position. If the price action is below the moving average, they will take a short position.

Using two moving averages, such as the 50-day and 200-day moving averages, can help you identify an uptrend in a financial market.

For example, you could plot both the 50-day moving average (representing a shorter-term average) and the 200-day moving average (representing a longer-term average) on your price chart. Because you're looking for an uptrend, which is characterised by higher highs and lower lows, you want to see the price consistently trading above both the 50-day and 200-day moving averages.